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Illinois Tool Works Investment Report

 

ITW:  05/30/2007

 

Current Price: @ US $52.46 / Market Cap: $29b / Dividend: $0.84 (1.60%)

 

Illinois Tool Works is an industrial conglomerate with a portfolio of 750+ businesses operating globally.  While the name may say tools, ITW is involved in many different industries some of which include industrial packaging, automotive components, construction supplies, welding equipment, testing systems – the breadth of ITW’s reach is really too extensive to list here. 

 

Traditionally, Illinois Tool Works has employed a heavily decentralized business model – resembling a holding company to some degree.  The top brass puts the onus on business units to perform, requiring only a minimum of financial target reporting to ensure that the units are using ITW’s 80/20 model (focus on the 20% of customer base that provides 80% of revenues) to achieve company fiscal targets (historically, mid-teen operating margins with 4% organic growth).

 

ITW relies heavily on acquisitions to achieve growth (typically, acquisitions comprise more than half of revenue and income growth).  Historically, the company targets small, privately-held businesses at prices around 1x annual revenues.  With the ascension of David Speer to the role of CEO, ITW has stepped up this part of their business plan.  They’ve trained 150 of their business unit managers in the art of ITW acquisitions and made them responsible for these smallish-acquisitions while the corporate big-wigs handle the larger acquisitions (more than $100 million in revenues) which can serve as possible new industry platforms.  Also, they are focused on expanding international revenues with an emphasis on Asia and diversifying from the auto and construction industries which accounted for 37% of 2006 revenues, already lower than 1996’s 42%.

 

Risks

  • Ramped-up acquisition strategy may backfire.  While ITW has operated under its decentralized, acquisitive business model for decades, its size ($29 billion market cap) and the maturity of North American markets have led to this next level of acquisition activity.  The company has trained 150 of its best and brightest over the last 18 months or so to handle acquisitions as well as implementing an ongoing program that expects to churn out another 70 M&A experts this year.  How many of these 220 wannabe Warren-Buffetts will be competent, much less excellent?  The company has put a large part of its future in these folks’ hands.
  • 37% exposure to the automotive and construction (re: housing) markets.  While the company asserts that exposure to the Detroit big 3 and housing makes up only 10% of revenues, it has admitted that it underestimated the severity of the US housing downturn which has impacted results.
    • The company sees a bottom close at hand as it relates to housing starts.  If it’s wrong, results may be impacted even more.
    • ITW also has 8% revenue exposure to international construction markets.  Any housing downturns in parts of Europe may possibly affect their faster growing international segments.
    • U.S. auto industry doesn’t look like its getting better any time soon.
  • A core focus of future growth for the company is Asia where the company hopes to grow revenues from 2006’s $815 million to $4 billion (20% of revenues) by 2010.  For perspective, 2006 saw ~$14 billion in revenues).   Any hiccups in the Asian growth story may negatively impact future returns.
    • Emphasis on China, whose role in the world is still being defined
      • Possible trade wars.
      • Possibly overheating economically.
      • Unclear if China can “decouple” from US economy
    • Exposure to India is limited and if it grows, will be later in the cycle
      • Only 1 significant business in India (Signode)
  • Exposure to raw material costs.  2 commodities highlighted during the 2006 analysts meeting was nickel (stainless steel) and oil (chemicals & plastic resins).
    • While predicting commodities prices isn’t advisable, a defensive posture towards rising commodities markets would be prudent.
    • As far as “Hot Commodities” go, oil and nickel are two of the hotter ones.
  • The company’s decentralized model is a key component of ITW’s business plan.  If their business came under pressure, it would be difficult for ITW to implement streamlining measures outside of their 80/20 strategy (ie, operating synergies, consolidation, etc). 

 

Upside:

  • Illinois Tool Works has a solid track record.  Highlights from 1996-2006:
    • Revenues have increased from $6.7 billion in 1996 to $14 billion in 2006, averaging 7.75% annual growth over that time span.
    • ROIC  Avg: 15%  2006: 18.6%  
      • Since ITW dependent on acquisitions, this ROIC differs from the Greenblatt ROIC measure in that goodwill and intangibles are included (in the denominator).  If using the Greenblatt measure, the 2006 figure would ~32%.
    • Operating Income Margin – Avg: 15%,  2006: 17%
    • Dividend Increase 9 of 11 years with an 11-year average increase of 15.6% annually.
  • The company throws off crazy cash, with free cash flow roughly equal to net income.  As investing is rife with clichés, here’s one: CASH IS KING.
  • 40% of revenues coming from overseas.  Also, the international portion of operating income is increasing relative to North America.
  • Faster growth in their higher margin Specialty Systems segment relative to the Engineered Products segment.
  • The company is well-positioned to weather an economic downturn.  The company’s capital restructuring process belies its position:
    • Trying to increase leverage, targeting a debt-to-equity ratio of 20-25% from it’s current 16%.
    • Raised its dividend-payout targets to 25-35% of 2-yrs trailing net income
    • Share repurchase of $500-$700 million
    • Still prepared for any large acquisitions if opportunity comes.

 

Competitors

I reviewed the following industry competitors:

 

1.      Dover – smaller industrial conglomerate with similar decentralized philosophy

a.      Pros

                                                                           i.      Good potential for both organic and acquisition growth

                                                                         ii.      Attractive portfolio composition

                                                                        iii.      43% of revenues from overseas

                                                                       iv.      50 straight years of dividend increases

b.      Cons

                                                                           i.      Not as solid as ITW in terms of being able to weather a down business cycle (lost money in 2002)

                                                                         ii.      Lower margins and return-on-capital numbers

                                                                        iii.      Not as stringent in acquisition valuations

                                                                       iv.      Goodwill + intangibles account for over half of assets

2.      Danaher – successful & aggressive conglomerate

a.      Pros

                                                                           i.      High quality-of-earnings as their operating segments have are in higher margin platforms relative to peers

                                                                         ii.      Like the others we’ve discussed, strong free cash flow

                                                                        iii.      Higher growth projected than either Dover or ITW

                                                                       iv.      Business operations reminiscent of private equity methods

                                                                         v.      Good position for any cyclical downturn

b.      Cons

                                                                           i.      Paltry dividend yield (0.1%) despite strong balance sheet & cash flow.

                                                                         ii.      The nature of their acquisitions exposes them to more competition for good deals.

 

Management:

  • Integrity: Inc.  David Speer CEO:  Speer has been on the job less than 2 years, having taken the reins from mentor, Jim Farrell.  In general, Illinois Tools invests in its people as both Farrell and Speer have been decades with ITW.  Also, their M&A training program demonstrates the commitment they make to their people
  • Past Performance: A. The track record and numbers speak for themselves.

 

The Story:

A stodgy, old-economy company that performs year-in, year-out, Illinois Tool Works is entering a new phase of its life.  While some of its competitors also employ the decentralized management model, ITW has built an acquisition army to fuel its growth.  And for me, this adds some uncertainty to ITW’s otherwise mundane business. 

 

That aside, ITW is reminiscent of Ben Graham’s approach to picking stocks.  Whereas other competitors may be willing to pay premiums to acquire promising businesses, ITW prefers to buy smaller-sized companies (which means less competition as private equity look for bigger fish) at about 1X revenues and then use their 80/20 strategy to expand margins.  And it’s been highly successful.

 

If their acquisition army is reasonably trained and able, that success should continue into the future. 

 

Valuation:  

A modified DCF model gives me an intrinsic value of $58 to $60.  This assumes a growth rate ranging from 7 to 10%.  FCF growth over the last 11 years has averaged over 11% while revenue growth has averaged 7.75% annually over the same time frame.

 

Their 2006 ROIC number was 17%.  As noted earlier, if you exclude goodwill and intangible assets per Joel Greenblatt, ROIC is over 30%, though this wouldn’t be sound for valuation as acquisitions (and hence goodwill) is vital to their business.  However, goodwill + intangibles comprise 36% of total assets (compare to Dover’s 50+ percent).  Return on assets is nearly 12%.

 

Certainty Rating: B-. 

While ITW has a long record of increasing shareholder value and good returns, I’m not completely sold that ITW can hit the targets they’ve set for themselves.  Increasing base revenue growth from its historical 4% rate to 5-6% is nice but I can’t see how they’re going to get there yet (not saying they can’t but rather I haven’t seen a strategy that shows exactly how they plan on doing it).  Their overseas expansion looks good though analysts sound skeptical that they’ll hit that number.

 

That said, while I’m giving them a B- on the uncertainty rating as it relates to their stated growth targets, their business and operations are solid enough that if ITW fell 20-25% below intrinsic value, I’d have no problem buying at those levels as their core business will provide support for investment.

 

Economic Value Measurements:  

·         Base revenue growth trending up towards 4% historical rate for 2007 (and above future years).

·         Expanding revenues and operating income % from International segments.

·         ROIC staying around 17%.

·         Operating margins eventually coming back to 17% as acquisitions roll into base classifications (1 year post acq)

·         Increased dividends.

 

Intrinsic Value Range: $58 to $60

Accumulation Range: nibble at $48 and buy with confidence @ $46 or better (for a ~20-25% margin of safety)

 

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